What do you mean by watered stocks?
Watered stock refers to the shares of a corporation that are issued at an inflated value to dupe
investors. As a result, the value of these shares is projected much higher than their
intrinsic value. The last known incident of issuance of watered stock took place more
than a decade ago. Many structures and regulations have been introduced to guard the way companies
artificially inflate the value of their stocks. Watered stocks are also termed as securities
fraud. It is believed that the term was derived from ranchers who would make their livestock
drink large quantities of water before selling them to the investors in the market. Through
this method, the cattle gained extra weight because of the water consumed and looked deceptively
heavier, allowing the ranchers to get higher prices for them. Daniel Drew invented the
term watered stock in the finance world. Drew was a cattle driver turned financier.
Frequently Asked Questions Discuss few reasons why corporations artificially
inflate the value of their assets? There are various reasons for the overvaluation
of the underlying assets. Some of these reasons include inflation of accounting values—
such as a one-time artificial increase in stocks or property value. Similarly, the overvaluation
can also be due to excessive stock issuance via a stock dividend or an employee stock-option
program.
Perhaps not in every single case, but often during the late 19th century, owners of a
corporation would make exaggerated claims about a company's profitability or assets,
with an intent to sell the shares of the concerned company at an inflated value. Since the corporation
sold the shares at a par value far higher than the book value of the assets, the investors
had to bear massive losses, which helped the fraudulent owners make huge gains. In addition,
a company's profitability was shown high by contributing property to the company in exchange
for the stock of inflated face value. This resulted in an increase in the company's value
on the balance sheet, although the company held far fewer assets than reported. All this
is done to deceive and cheat the investors.
.
How did the practice of companies issuing watered stock come to an end?
Companies stopped with the practice of watered stocks after they were forced to issue shares
at a low or no face value (par value), mainly under the attorney's advice who were aware
of the potential for the watered stock to create liability for investors.
Gradually, investors became suspicious about the claim that the nominal value of stock
represented the stock's actual value. Additionally, accounting guidelines were also updated to
ensure that the difference between the value of assets and no or low par value were accounted
as additional paid-in capital or capital surplus.
What are the different causes of watered stocks?
Watered stocks can prove advantageous for those companies which use the market misinterpretation
regarding the stocks by selling the stocks at an overvalued price and register huge profits.
The three important causes of watered stock are:
Failure in the adoption of depreciation policy.
Acquisition of a company's property at an exorbitant price.
Purchase of worthless intangible assets at a very high price.
What do critics say about watered stocks?
Image Source: © Flynt | Megapixl.com
Over the years, the practice of watered stock has garnered widespread criticism by various
experts, which includes those associated with Social Gospel Movement like Walter Rauschenbusch
and George D Herron. The critics highlighted specific points with respect to the issuance
of watered stocks:
While uncovering the fraud, creditors' liability is shifted to the less informed holders of
the watered stocks.
New investors or those who lack experience tend to struggle in a market damaged by watered
stocks. This is because these types of investors do not possess the ability to do detailed
research and compute relevant data.
Most of the time, the investors fall into the trap of marketed stocks, and when they
realise this, the only option available before them is to sell these stocks
at low prices. Thus, the investors